The previous balance method calculates costs and interest based on the previous billing cycle’s outstanding balance, resulting in higher finance charges. The adjusted balance method considers payments and purchases made during the current billing cycle, resulting in lower fees. Retail stores use the average daily balance method, which can reduce fees but often comes with higher interest rates.
The previous balance method is used in finance and accounting to calculate costs and interest based on the amount due from the previous billing cycle. For a credit card account, the interest rate is applied to the outstanding balance from the prior billing period to determine the current finance charge. Payments and charges made during the current billing cycle are not included in the calculation. The above balance method generally results in higher finance charges than the adjusted balance method and lower fees than average daily balance calculations.
This accounting technique is often seen as favoring the credit issuer. Basing an account’s finance charges on the previous month’s outstanding balance may result in interest being charged on a balance even after it has been paid. However, by not including charges for the current period, the previous balance method ensures that there will be no new finance charges incurred until the end of the billing cycle. This generally gives consumers 30 days to pay for new purchases without assessment of a finance charge.
For example, consider an account that had an outstanding balance of 1,000 currency units at the end of a billing cycle. Suppose that during the current period there was a payment of 100 units and a purchase of 50 units. At the end of the current period, the account would have an outstanding balance of 950 units. However, using the prior balance method, the finance charge would be calculated on the prior month’s ending balance of 1,000 units. If the APR were 12%, the periodic rate would be 1% and the finance charge would be 1000 * 0.01 = 10 units.
Unlike the previous balance method, the adjusted balance method is considered to favor the consumer. This method represents all payments and purchases made during the current billing cycle. The account balance at the end of the current cycle is the basis for calculating finance charges. If an account entered the current billing period with a balance of 1,000 currency units, made a payment of 100 units, and made a purchase of 50 units, the ending balance would again be 950 units. However, the finance charge, calculated at the above rate, would be 950 * 0.01 = 9.5 units.
Retail stores often use the average daily balance method to calculate their account charges. Any outstanding balance is calculated at the end of each day. Charges are added and payments subtracted as they occur. At the end of the billing period, the daily totals are averaged and the result is used as the basis for calculating finance charges. While this method can reduce fees for a given rate, department stores typically charge a much higher interest rate than bank-issued cards.
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